9ECH01

7/28/2019 9ECH01

1/56

7/28/2019 9ECH01

2/56

CHAPTER 1

An Overview of Financial

Markets and Institutions

7/28/2019 9ECH01

3/56

Copyright 2006 John Wiley & Sons, Inc. 3

The F inancial System

Provides for efficient flow of funds from

saving to investment by bringing savers and

borrowers together via financial markets

and financial institutions.

7/28/2019 9ECH01

4/56


Exhibit 1.1Transfer of Funds

7/28/2019 9ECH01

5/56


Basic components of the f inancial system:Markets andinstitutions.

Financial markets are markets forfinancial

instruments, also calledfinancial claims or

securities.

Financial institutions (also calledfinancial

intermediaries) facilitate flows of funds from

savers to borrowers.

7/28/2019 9ECH01

6/56


Economic units with f inancial needs:Households, Businesses,

Governments.

Households supply labor, demand products, and

save for the future.

Businesses demand labor, supply products, and

invest in productive assets.Governmentscollect taxes and provide public

goods (e.g. education, defense).

7/28/2019 9ECH01

7/56


Budget positions creating financial needs of economic units:

Surplus ordeficit.

Surplus spending units (SSUs) have incomefor the period that exceeds spending,resulting insavings.

Other words for SSU aresaver, lender, orinvestor. Most SSUs are households.

Deficit spending units (DSUs) havespending for the period that exceeds

income.Another word for DSU is borrower. MostDSUs are businesses or governments.

7/28/2019 9ECH01

8/56


Financial claims arise as SSUs lend to DSUs.

SSUs claim against DSU is liability toDSU and asset to SSU.

Ones liability is anothers asset: What ispayable by one is receivable by another.

Assets arising this way are financialassets.The financial system balances-total financial assets equal total liabilities.

7/28/2019 9ECH01

9/56


Marketability: Ease with which a f inancial asset may be sold to

another SSU.

Ability to resell financial claims makes them

more liquid by giving SSUs choices:

Match maturity of claim to planned investment

period;

Buy claim with longer maturity, but sell at end of

period; or

Buy claim with shorter maturity, then reinvest.

7/28/2019 9ECH01

10/56


Di rect F inancing: The simplest way for

funds to flow.

DSU and SSU find each other and bargainSSU transfers funds directly to DSU

DSU issues claim directly to SSU

Preferences of both must match as to--Amount

-Maturity

-Risk

-Liquidity

7/28/2019 9ECH01

11/56


Di rect F inancing: eff icient for large transactions if preferences

match.

DSUs and SSUs seize the dayDSUs fund desired projects immediately.

SSUs earn timely returns on savings.

Direct markets are wholesale markets.

Transactions typically $1 million or more.

Institutional arrangements common.

7/28/2019 9ECH01

12/56

7/28/2019 9ECH01

13/56


Pr ivate placements are simplest.

DSU sells whole security issue to one

investor or investor group.

Advantages include speed and low

transactions costs.

7/28/2019 9ECH01

14/56


Investment bankersunderwrite new issues of securities.

Buy entire issues of securities from DSUs

Find SSUs to buy securities at higher price

Profit from difference - underwriting

spread

7/28/2019 9ECH01

15/56


Brokers anddealers

Brokers buy or sell at best possible price fortheir clients.

Dealers make markets by carryinginventories of securities.

buy at bid pr ice; sell at ask pr iceBid-ask spread is dealers gross profit

7/28/2019 9ECH01

16/56


Problem with direct financing: DSUs and SSUs cannot always match

preferences.

Not every SSU can afford wholesale

denominations of $1 million or more.

DSUs and SSUs often prefer different terms

to maturity.

7/28/2019 9ECH01

17/56


Indirect Financing (Financial Intermediation):

Financial intermediariestransform

claims:

raise funds by issuing claims to SSUs;

use funds to buy claims issued by DSUs.

Claims can have unmatched characteristics:

SSU has claim against intermediary;

Intermediary has claim against DSU.

7/28/2019 9ECH01

18/56


F inancial intermediaries transform claims

7/28/2019 9ECH01

19/56


Famil iar forms of f inancial intermediation

Commercial Banking

Insurance

7/28/2019 9ECH01

20/56


Commercial Banks

Take deposits and make loans -

Depositors are SSUs

Borrowers are DSUs.

7/28/2019 9ECH01

21/56


I nsurance Companies

Issue policies, collect premiums, and invest

in stocks and bonds.

Policyholders are SSUs;

Businesses or governments are DSUs.

7/28/2019 9ECH01

22/56


Benefits of f inancial intermediation are a primary rationale for the

f inancial system.

Financial intermediaries lower the cost of financial

services as they pursue profit.

Financial intermediaries perform 5 basic services

as they transform claims.

7/28/2019 9ECH01

23/56


I ntermediar ies lower the cost of financial services as they pursue

profit.

3 sources of comparative advantage:

Economies of scaleTransaction cost controlRisk management expertise

Competition pulls interest rates down

Financing less costly

Projects have higher NPVsInvestment in real assets boosts economy

7/28/2019 9ECH01

24/56


I ntermediaries perform 5 basic services as they transformclaims.

Denomination Divisibi l i typool savings of many

small SSUs into large investments.

Currency Transformationbuy and sell financialclaims denominated in various currencies.

Maturi ty F lexibil ityOffer different ranges ofmaturities to both DSUs and SSUs.

7/28/2019 9ECH01

25/56

4 M j t f f i i l i t di i t f l i t t

7/28/2019 9ECH01

26/56


4 Major types of f inancial intermediar ies transform claims to meet

var ious needs.

Deposit-type or Depository Institutions

Contractual Savings Institutions

Investment Funds

Other Institutions

7/28/2019 9ECH01

27/56


Depository I nsti tutions take deposits and make loans.

Commercial Banks

Thrift InstitutionsSavings & Loan AssociationsSavings Banks

Credit Unions

7/28/2019 9ECH01

28/56


Commercial Banks

Largest single class of financial institution

Issue wide variety of deposit products -

checking, savings, time deposits

Carry widely diversified portfolios of loans,leases, government securities

May offer trust or underwriting services

7/28/2019 9ECH01

29/56


Thr if t I nstitutions

Closely resemble commercial banks

Focus more on real estate loans, savings deposits,

and time deposits

7/28/2019 9ECH01

30/56


Credit Unions: Unique Character istics

Mutual ownership -owned by depositors

or members

Common bond - members must share

some meaningful common association

Not-for-profit and tax - exempt

Restricted mostly to small consumer loans

7/28/2019 9ECH01

31/56


Contractual I nsti tuti ons bring long-term savers and borr owers

together.

Life Insurance Companies

Casualty Insurance Companies

Pension Funds

7/28/2019 9ECH01

32/56


L ife I nsurance Companies insure against lost income at death.

Policyholders pay premiums, which are

pooled and invested in stocks, bonds, andmortgages

Investment earnings cover the costs and

reward the risks of the insurance company

Investments are liquidated to pay benefits.

C l t I C i t i t l

7/28/2019 9ECH01

33/56


Casual ty I nsurance Companies cover property against loss or

damage.

Sources and uses of funds resemble those oflife insurers, but

Casualty claims are not as predictable asdeath claims; so

More assets are in short-term, easily

marketable investments

7/28/2019 9ECH01

34/56


Pension Funds help workers plan for reti rement.

Workers and/or employers makecontributions, which are pooled andinvested in stocks, bonds, and mortgages

Net of administrative costs, investmentearnings are reinvested and compounded

Retirement benefits replace paychecks (atleast partly)

I nvestment F unds help small investors share the benefi ts of large

7/28/2019 9ECH01

35/56


I nvestment F unds help small investors share the benefi ts of large

investments.

Mutual Fundsprovide intermediated access to

various capital marketsshareholders money is pooled and invested instocks, bonds, or other securities according tosome objective

Money Market Mutual Funds(MMMFs) areuninsured substitutes for deposit accounts

MMMFs buy money market instrumentswholesale, pay investors interest, and allow

limited check-writing

7/28/2019 9ECH01

36/56


Other Financial Institutions

Finance Companies

Make loans but do not take deposits; raiseloanable funds in commercial paper market andfrom shareholders

Federal Agencies

Issue agency securities backed by governmentand lend at sub-market rates for favored social

purposes

7/28/2019 9ECH01

37/56


7/28/2019 9ECH01

38/56


7/28/2019 9ECH01

39/56


F inancial Markets are classif ied in several ways.

Primary and Secondary

Organized and Over-the-Counter

Spot and Futures

Options

Foreign Exchange

International and Domestic

Money and Capital

7/28/2019 9ECH01

40/56


Primary and Secondary Markets

Primary marketsare where financial claims are

born: DSUs receive funds, claims are firstissued

Secondary marketsare where financial claimsliveare resold and repriced

Claims become more liquid because SSUscan set their own holding periodsTrading sets prices and yields of widely held

securities

7/28/2019 9ECH01

41/56


Organized and Over-the-Counter Markets

Organized Exchanges:physical, relatively

exclusive.Physical trading floor and facilities available tomembers of exchange, for securities listed onexchange.

New York Stock Exchange

Chicago Board of Trade (futures)

OTC Markets: virtual, relatively inclusive.

Decentralized network available to any licensed dealerwilling to buy access and obey rules, for wide range ofsecurities.The NASDAQ is a famous OTC market.

S t d F t M k t

7/28/2019 9ECH01

42/56


Spot and Futures Markets

Spot Markets: immediate payment for immediate

delivery

Futuresor Forward Markets: immediatepayment for promise of future delivery

Futures contracts: standardized as to amounts,forms, and dates; trade on organized exchanges

Forward contracts: individualized between

parties with particular needs

7/28/2019 9ECH01

43/56


Option Markets

Rights in underlying securities or commoditieswriter grants owner some exclusive right for somecertain time

Main types of options: Puts(options to sell)Calls(options to buy)

Options on listed securities and widely heldcommodities trade actively on organizedexchanges

F i E h M k t

7/28/2019 9ECH01

44/56


Foreign Exchange Markets

Any currency is convertible to any other at some

exchange rate

Forex involves spot, future, forward, and option

markets

I t ti l d D ti M k t

7/28/2019 9ECH01

45/56


I nternational and Domestic Markets

Help participants diversify both sources and uses

of funds

Examples of major international markets:

EurodollarsUS dollars deposited outside U.S.Eurobondsbonds issued outside US but

denominated in $US

M d C it l M k t

7/28/2019 9ECH01

46/56


Money and Capital Markets

Money markets: wholesale markets for short-term

debt instruments resembling money itself

Capital markets:where capital goods are

permanently financed through long-term financial

instruments(Capital goodsreal assets held long-term toproduce wealthland, buildings, equipment, etc.)

M M k t

7/28/2019 9ECH01

47/56


Money Markets

Help participants adjust liquidityDSUs borrow short-term to fund currentoperations

SSUs lend short-term to avoid holding idle cash

Common characteristics of money marketinstrumentsShort maturities (usually 90 days or less)

High liquidity (active secondary markets)

Low risk (and consequently low yield)Dealer/OTC more than organized exchange

Examples of Major Money Market Instruments

7/28/2019 9ECH01

48/56


Examples of Major Money Market Instruments

Treasury Bills

Negotiable Certificates of Deposit

Commercial Paper

Federal Funds (Fed Funds)

7/28/2019 9ECH01

49/56


Money Market BalanceSheet Position of Major Participants

7/28/2019 9ECH01

50/56


Money Market Balance Sheet Position of Major Participants

COMMERCIALBANKS

FEDERALRESERVESYSTEM

TREASURYDEPARTMENT

INVESTMENTBANKS,

DEALERS,AND BROKERS CORPORATIONS

INSTRUMENT A L A L A L A L A L

Treasury bills

Agency securities Negotiable CDs Commercial paper Bankers acceptances Federal Funds Repurchase agreements

C it l M k t

7/28/2019 9ECH01

51/56


Capital Markets

Help participants build wealth

DSUs seek long-term financing for capital projectsSSUs seek highest possible return for given risk

Differences from money marketsLong maturities (5 to 30 years)

Less liquidity(secondary markets active but more volatile)

Higher risk in most cases(with higher potential yield)

Traded wholesale and retail on organized

exchanges and in OTC markets

Examples of

7/28/2019 9ECH01

52/56


p

Major Capital M arket Instruments

Common stock

Corporate bonds

Municipal bonds

Mortgages

7/28/2019 9ECH01

53/56


Eff iciency in f inancial markets

7/28/2019 9ECH01

54/56


Eff iciency in f inancial markets

Al locational Ef f iciency:highest/best use of funds

DSUs try to fund projects with best cost/benefit ratios

SSUs try to invest for best possible return for givenmaturity and risk

I nformational Ef f iciency:prices reflect relevantinformation

Informationally efficient markets reprice quickly onnew information;

informationally inefficient markets offer opportunitiesto buy underpriced assets or sell overpriced assets

Operational Eff iciency:transactions costs minimized

Risks of F inancial I nstitutions

7/28/2019 9ECH01

55/56


Risks of F inancial I nstitutions

Creditor default r isk: risk that a DSU may not

pay as agreed

I nterest rate r isk: fluctuations in a security's priceor reinvestment income caused by changes inmarket interest rates

L iquidity r isk: risk that a financial institution maybe unable to disburse required cash outflows, evenif essentially profitable

Risks of F inancial I nstitutions cont

7/28/2019 9ECH01

56/56

Risks of F inancial I nstitutions, cont.

Foreign exchange risk: effect of exchange ratefluctuations on profit of financial institution

Political r isk: risk of government or regulatory

action harmful to interests of financial institution.

Documents

9ECH01